Rates Jump, Markets Fall

Last week provided market drama not seen in some time. Although US markets were up on Friday, all domestic indices were down significantly for the week. Whenever we experience such a week, we find it valuable to objectively review the root causes. In every market environment, there is typically more than one factor at play. Last week, the International Monetary Fund (IMF), reduced its expectation for 2018 global growth from its forecast in April (from 3.9% to 3.7%)[1]. On its own, such a forecast might not have been enough to push markets lower. The problems arose when US Treasury rates were simultaneously moving higher.

We have long believed that the US interest rate market, particularly since the Great Recession, has provided an amazingly accommodative environment for economic growth. During the crisis just about ten years ago, with employers hemorrhaging workers and profits sinking, the Federal Reserve acted on the belief that historically-low interest rates would have a stimulating and supportive effect on multiple areas of the US economy. So far, this has proven to be correct. Stock market, housing, and employment gains since this period are undeniable. Since that time, there has always been a question of how such an accommodative environment would be removed. The “training wheels” at some point would have to be taken off.

Over the past month, the most noticeable interest rate move has been in the 10-year treasury. The 10-year is not the shortest or longest rate but more of a proxy for borrowing costs, particularly home mortgage rates. Today, the 10-year sits at around 3.15%, a marked increase from 2.28% just one year ago. As one might assume, mortgage rates have increased similarly. Interestingly, most economists agree that a more “normal” (still higher from where we are) rate environment would be better for all of us in the long run. By letting the market dictate the environment, the economy will be healthier as risk is most properly priced. Our biggest concern is the pace by which rates normalize. If we look at the one-year chart[2] below, the 38% increase in the 10-year treasury is quite evident.

If we look over a much more extended period[3], a 10-year treasury rate of 3.15% is still quite low. The chart below reflects the 10-year treasury since 1970. Visibly, the recent run up in rates is almost undiscernible.

We believe markets will continue to react to interest rate movements for the foreseeable future. As much as we dislike negative markets similar to last week, we understand that increased volatility may be a part of a normalizing rate environment. We believe rates can continue to increase along with an expanding economy as long as rate increases are measured and not violent. Second, it is important to point out that a continually improving economy is the backdrop of these rate increases. Extremely low unemployment and record corporate profits have accelerated economic growth. We have to believe that the Fed envisioned such an eventual result when it chose to promulgate such an accommodating environment just a decade ago. As much as we would prefer to avoid weeks like the last one, we understand that an economic backdrop of low or negative growth along with high unemployment would be far more troubling.